Yield, the Oldest Scam in the Books

There are two ways to fleece (cheat) someone: appeal to their greed, or appeal to their fear. But the most effective approach that I know of is to appeal to elderly investors who did not save enough, and are finding it difficult to make ends meet. They don’t want to take big chances, but they do need the yield.

Before I go on, what is yield? This sounds like a dumb question — the simple answer is the percentage of money remitted to investors relative to the market value of the security. And that is true as far as it goes, but there is more wood to chop here.

Yield is four things:

The risk free return on capital over a specified horizon.

The return required in order to induce someone to give up liquidity if the bond is not marketable.

The return required to take on any optionality, whether call or put risk, conversion, prepayment or extension risk.

The return needed to compensate for the possibility of default.

I have written before against buying structured notes from Wall Street. Retail investors, take note. Wall Street knows more than you do, and you are the patsy at their poker table. The deck is stacked against you. Avoid buying their products where they try to sell you an enhanced yield in exchange for a less certain return of principal, whether due to default, prepayment, call, or extension.

Though there are instruments that are undervalued, yielding more then they ought to, most of the time high relative yields indicate high risk. Stretching for yield is usually a mistake. With bonds and preferred stocks, it usually means more credit risk. With equities and LPs, it usually means paying out more than the underlying cashflows from operations can handle, which is another form of credit risk. Dividends can be reduced quickly if the cashflows can’t support them.

Now I turn to the article that drove this piece: Nonlisted REIT Sales Get Heightened Scrutiny by Finra. Anytime you buy a security without a secondary market, you leave yourself at the mercy of the company. Liquidity is poor, but the poor fool who buys these investments does not consider how much extra yield he needs to compensate for illiquidity. Instead, he looks at his income needs, and buys. Do you really want to play in someone else’s casino? The casino analogy is apt, because the company controls the dividend payout and the buyback price. Worse still, they have a better idea of what the asset are worth than the investors do. Those with short-term cash flow needs are in a bad spot investing with them; they will not get the true economic value of their holdings. (But, they should have planned for it — anytime one takes on illiquidity, one should make sure that there is enough liquidity elsewhere to compensate.)

With listed REITs, an investor has real estate equity or debt levered up through borrowings. A nonlisted REIT is the same, except that there is no third party market to buy and sell shares. You owe your soul to the company store, though you the the creditor, not the debtor. My view is simple here: don’t buy into roach motels for cash, where the cash goes in easy, and comes out hard, unless you can negotiate your own terms.

Don’t give up liquidity without fair compensation. I am happy to say that in my personal and professional investing career, I have never taken a loss off of illiquid investments. Why? Because they have to be bulletproof to me before I invest. They must have table stability, not just bicycle stability. Can they pay me back when liquidity is scarce?

……….

I have been through three exercises at the firm I work for where a life settlements securitization has been proffered to us as a great way to start up a securitization business. Every one of them was bogus, and I protected the firm by telling them not to do the deals.

The life settlements seemingly carry a lot of yield, so it takes some backbone to suggest that there is not enough yield, or that capital losses will eat up yield, so the deal should not be done. For a time, I ended up saving the firm. The lesson is this: in investing, ignore yield to the greatest extent possible. Focus instead on earning a good return, with safety, and ignoring the payout. It is a little known secret that REITs with the lowest payouts tend to be the best performers over the intermediate-to-long term. It is easier to earn money off of taking equity risk than credit risk.

So, aim for best advantage in investing. Don’t trust yields, but rather look at the underlying economics of the business that you are investing in or lending to. Yes, it is a lot more work, but it is work that you should be doing.

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.